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Drugstore.com, Inc v. Director, Division of Taxation

23 N.J. Tax 624 (2008)

TAXATION — A business that operates in New Jersey and distributes its products in New Jersey, cannot avoid the obligation to pay sales tax by engaging in the artifice of establishing a non-New Jersey website for sales to customers in New Jersey if it uses its own distribution facilities in New Jersey to fill orders and merely handles all of the intercompany transactions on “paper.”

An online retailer of non-prescription pharmaceutical products, which was based out of state, began to sell items in New Jersey over the internet on a website also hosted and operated out of state. A distributor, which was a wholly owned subsidiary, operated from a warehouse in New Jersey. The retailer also owned an out-of-state subsidiary which purportedly received orders from customers on the retailer’s website and forwarded the orders for delivery to the distributor which then facilitated the delivery to in-state customers. The retailer was audited by the New Jersey Division of Taxation and was found to owe substantial sales taxes from sales to New Jersey customers during the audit period. The Director of the Taxation Division deemed the retailer to be a vendor responsible for the collection of sales tax from sales to New Jersey customers that originated in New Jersey, or alternatively responsible as a co-vendor responsible for the collection of such taxes due to the close relationship between the retailer and the distributor.

The retailer disputed the Director’s finding and brought an action in the Tax Court for a determination that it was only responsible for the operation of the out-of-state website and that it was not responsible for collecting sales tax for in-state customers who ordered goods from that website. During the proceedings, it was revealed from testimony given by an attorney for the retailer that the out-of-state subsidiary had no employees or physical presence and that all of its purchasing and administrative functions were contracted to the retailer and its distribution functions were contracted to the distributor. It was also revealed that relationships between the retailer and the distributor and between the retailer and the out-of-state subsidiary were governed by written agreements, all of which were signed by the same individual who was the chief financial officer of all three entities. The agreements between all of the entities covered service, support, trademarks, and licensing.

It was also revealed during the proceedings that the services and support provided by the retailer to the out-of-state subsidiary included all of its functions, including the processing of credit card information and receipt of customer payments. The retailer and the out-of-state subsidiary maintained mutual capital accounts for each other which were adjusted for financial transactions instead of by means of actual payments. The distributor and the out-of-state subsidiary also had an agreement under which the distributor was the sole distributor for the out-of-state subsidiary. The agreement also indicated that there was to be no indication of a distinction between the two subsidiaries on the website, which was designed by and hosted by the retailer.

The retailer argued that it was not a vendor according to the law, that it did not make the sales in question, and that the sales were made by the out-of-state subsidiary which had no substantial nexus, or relationship, with New Jersey. According to the retailer, the out-of-state subsidiary purchased the goods sold to in-state customers from the distributor, but the Tax Court found no evidence of such transactions. The Tax Court pointed out that even if such transactions were found to exist on the record, an examination of the actual conduct of the parties would ultimately determine whether such transactions took place and whether the retailer was responsible for collecting sales tax. The Tax Court also found that there was never any physical transfer of, or transfer of title to, the goods from the distributor to the out-of-state subsidiary.

The Tax Court determined that the out-of-state subsidiary was not a separate entity from the retailer because it had no employees and because all of its functions as a retail seller were contracted to the retailer and the distributor under the service and support agreements. It pointed out that the agreements between the retailer and the out-of-state subsidiary would have voided the agreements between the parties in the event that the voting stock of the out-of-state subsidiary was to come under the ownership of any entity other than the retailer. The Tax Court rejected the argument by the retailer that the creation of the three purportedly separate business entities was to allow flexibility for the formation of contractual relationships with third parties. It found that there would have been no reason or incentive for any third party to enter into a contract with the out-of-state subsidiary, which existed in name only and had contracted out all of its functions. The Tax Court also found that the only purpose of the out-of-state subsidiary was to bolster the retailer’s claim that its only function was the operation of the website and that it was not involved in the sale of goods to in-state customers.

The Tax Court additionally rejected the retailer’s argument that its in-state employees were only involved in the sale and distribution of prescriptive pharmaceutical products. It pointed to evidence which indicated that at least one of the retailer’s in-state employees researched over-the-counter products. The Tax Court acknowledged that the retailer’s sales activities did not take place in state, but pointed out that the definition of a vendor is a person who maintains a place of business within the state and makes sales of goods taxable under state law whether the goods were sold in or out of state. The Tax Court concluded that the retailer was an actual vendor in New Jersey and that the Director for the Division of Taxation properly assessed sales tax on the retailer for its sales to New Jersey customers during the audit period.


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